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Alternative investments are finally getting respect. For years, they've been the expensive disappointments of the portfolio, overshadowed by basic stock indexes and equity funds. U.S. equities soared 30% last year and gained 150% since early 2009. Suddenly, however, all that is changing. Hedge funds, private equity, and private debt are being extolled as some of the best ideas for wealthy investors' portfolios in 2014.

According to Penta's annual asset-allocation survey, which asks 40 of the nation's leading wealth-management firms to spell out in tactical detail their model-portfolio calls, advisors are still bullish on stocks for 2014. (See the full survey's results at the end of this story.) But they also foresee more-modest returns in equity, rising volatility and falling correlations between stocks, uncertainty in fixed income, and improving global economic growth. These are the ideal conditions for managers of hedge funds and private investments to shine.

"Alternatives have been a bad word for the past five years. They didn't serve you much because it's been a beta market," says Mike Wilson, chief investment officer at Morgan Stanley Wealth Management. With stocks often bouncing up and down in unison, hedge funds were hard-pressed to pick specific shares likely to outperform, or fall further than others. Result: Equity hedge-fund returns were less than half that of the S&P's return during the last five years. But now correlations between stocks have been falling. "It's become a lot more of an idiosyncratic market," Wilson says. "That creates a pretty good opportunity for hedge-fund stockpickers and macro traders."

Wilson could hardly summon a better example than January's reeling stock market. A jumble of worry about emerging-market economic instability and U.S. corporate earnings caused investors to dump stocks, sending global and U.S. markets into negative territory for the month. In contrast, many hedge funds had positive returns. While the MSCI World Index was down 3.8% and the Standard & Poor's 500 was down 3.6%, global equity long-short hedge funds were up 0.8% and event-driven hedge funds were up 0.3%, according to HedgeFund Intelligence, an industry data tracker.

The churning market, which helped hedge-fund managers find opportunities to aggressively short-sell stocks, is likely to continue as the Federal Reserve tapers its bond-buying stimulus program this year. "Last year, our job was to identify securities on the long side that would outperform, while the short side created a drag," says Tim Garry, co-manager of $700 million Passport Long/Short fund. "With the taper, the Fed has gone from being a tail wind to a head wind for certain markets. We think we can make money on both sides now." The fund posted a 1.9% return in January.

Alternatives are also being used as a portfolio hedge, acting as a substitute ballast at a time when bonds look risky. Total assets in all hedge funds, currently $2.6 trillion, surpassed their 2007 high in 2010, thanks mainly to the popularity of fixed-income hedge funds, acting as a replacement for core bonds. That trade-off has served many investors well.

While the S&P 500 fell 3.6% in January, long-short hedge funds were up 0.8%.
James Bennett for Barron's

"The headlines say hedge funds have been laggards, but if your hedge funds were funded by reducing your bond position, then they look great," says David Donabedian, chief investment officer of Atlantic Trust, who points out that his clients have earned a 25% return on their fixed-income hedge funds over two years through 2013, compared with about a 3% two-year return for the bond market.

Expectations are even higher this year for long-short hedge funds. After a year of stock market growth based on ever-higher multiples, a return to fundamentals has been causing poor-quality companies to underperform markedly, creating opportunities to short-sell across industries. "We had a variety of fundamental shorts that worked well for us, including retailers, organic grocers, and multilevel marketing companies," says Alex Roepers, founder and chief investment officer of Atlantic Investment Management, which runs several hedge funds with $2 billion under management.

For such reasons, managers and their more risk-tolerant clients have been busy getting into position. By the time January's turbulence hit, many private banks, family offices, and independent investment firms had already raised hedge-fund allocations to include more exposure to equity-oriented strategies that can excel in volatile markets. Among them were JPMorgan Private Bank, U.S. Bank Wealth Management, Brown Advisory, Highmount Capital, Wells Fargo, and Morgan Stanley.

Firms also have a strong hankering for private equity, particularly investments in developing markets and fast-evolving sectors like energy and technology. Firms such as BNY Mellon Wealth Management, Fiduciary Trust, Goldman Sachs, U.S. Trust, and Highmount Capital have all raised private-equity allocations, and some dramatically so. Goldman's private-equity position went from zero last year to 14%.

Enthusiasm for alternatives is part of the continuing risk-on story we documented in our fall Penta cover ("Seeking Higher Returns," Sept. 16, 2013). In our new asset-allocation survey, three-quarters of the firms again raised their overall stock allocations to an average 51%, up from 48% this time last year and 45% in early 2012. Fixed-income holdings continued a two-year decline, now at an average 26%, down from 29% last year and 34% in 2012, reflecting concerns that rising interest rates could result in losses for bond investors.

The widely shared view is that developed-market stocks remain attractive, particularly in Europe and Japan. Most wealth managers are maintaining overweight positions to the U.S., expecting about an 8% return on the S&P 500 this year. While they have no immediate plans to expand U.S. stockholdings, they have been making changes within the asset class. "We're no longer at our low end of valuations in stocks, so we have tilted our allocation toward value," says Paul Chew, head of investments at Brown Advisory. He and other managers favor cyclical stocks, such as financials, technology, and industrials.

Which brings us back to hedge funds. While many firms' stock allocations are the biggest since before the 2008 market crash, they often don't fully reflect their bullish outlook on equities, because even more stock exposure is being sought in the alternatives area of the portfolio. "For a firm constructive on risk assets, our 39% in stocks doesn't seem like a high allocation, but that doesn't take into account the additional 12% in equity-oriented hedge funds," says Kate Moore, JPMorgan Private Bank's U.S. chief investment strategist.

Average recommended hedge fund and private-equity allocations are up to 14.1% from 12.5% last year; many firms that haven't increased their exposure to alternatives have instead been focusing on closing the gap between their recommended allocations and the actual exposure their clients have.

Let us not forget that, during the recession, many clients discovered precisely how illiquid alternative investments were, particularly holdings in private equity, where asset valuations fell through the floor. You couldn't get out for love or money. Investors are also, rather wisely, deeply suspicious of bankers pressing on them solutions that come bundled with a hefty 2% and 20% fee structure. "Clients say, 'Remind me again, Why do I need any of this stuff?' " says Leo Grohowski, BNY Mellon Wealth Management's chief investment officer.

We can help on that front: Keep your eye on the big picture. Stocks have dominated recently, but over longer periods hedge funds and private equity perform about the same or better, with less volatility. Consider the 15 years through 2012: the S&P 500 returned an average annual 4.4%; net of fees, hedge funds gained 4.2%, and private equity, 12%.

But -- and this is important -- according to the investment management firm BlackRock, stocks were more than twice as volatile as hedge funds during that period, and 50% more volatile than private equity. This suggests a portfolio that includes alternatives may have superior risk-adjusted returns over the long term.

"It's difficult to time when short periods of single-investment dominance will end," says Celia Dallas, chief investment strategist at Cambridge Associates, an alternatives consulting company. But when valuations climb as they have in U.S. stocks, it's prudent to diversify with hedge funds and private equity, she says.

Which is why the age of alternatives is here. Last year, assets in equity hedge funds finally surpassed their 2007 highs, closing 2013 at $734.1 billion, according to research outfit HFR. Capital raised by private-equity assets are still far off their 2008 peak -- at $467 billion versus $688 billion -- but last year, investors committed more money to the sector than they have in five years, and it's likely that the number is going to move significantly higher as the year unfolds.

There are, of course, many inherent risks in all of this, not least of which is mission drift. Equity hedge funds, if wisely chosen, can mitigate portfolio risk when they aim for returns with a low correlation to stocks and bonds. But this is where the picture starts getting muddied. The renewed interest in equity hedge funds -- long-short and event-driven strategies, in particular -- has as much to do with wanting higher returns as hedging risk, wealth managers tell us.

Which is why it pays to know as much as possible about where your alternative investments are placing their bets. Mark Yusko, manager of the Morgan Creek Tactical Allocation fund, has had success playing the long and short sides of one of the year's big themes: energy. The fund has a long position in energy producers; in January, Yusko took a short position in natural gas.

"When natural gas spiked over $5 in January, we were able to go short and make money in the fund," he says. The fund, one of a growing number of long-short mutual funds launched by hedge funds lately, gained 3.8% from Jan. 1 through Feb. 18 of this year.

PRIVATE EQUITY, MEANWHILE, is seen as the third ingredient in a "triple play" approach to earning equity or equity-like returns, says David Bailin, Citi Private Bank's global head of managed investments. "If you see opportunity in Europe, expand on a long-only mutual fund with a hedge fund that looks for credit opportunities, and a private-equity fund that invests in assets being divested from banks trying to restructure their balance sheets," Bailin says. "I find that very exciting."

Since many private investments have been wanting for capital, valuations are attractive, particularly in small- to midsize companies. "Private investments have traditionally been valued at an excess of a 10% discount to public opportunities because of their illiquidity aspect," says Tim Leach, chief investment officer at U.S. Bank Wealth Management. "Now we're seeing a decent discount beyond what's normal."

Bigger risk allocations have been funded partly by slashing exposure to commodities. With little inflation to hedge against and lingering price weakness, commodities' appeal has steadily waned over the past couple of years. Real estate allocations haven't changed much, though wealth managers are encouraged by the 12% increase in home prices last year. They like investments in rental properties and residential mortgage-backed securities.

One of the biggest asset-allocation challenges, wealth managers say, is in emerging markets. While the long-term outlook for developing economies remains favorable, near-term difficulties caused more than half of surveyed firms to reduce recommended holdings last year. Slowing growth in China, inflation in India, and corruption in Turkey are just some of the concerns that are likely to be compounded as the Federal Reserve tapers its bond purchases and interest rates begin to rise.

When interest rates rise, "global fixed-income managers begin to see Treasuries looking more attractive relative to emerging-market debt," says Rebecca Patterson, chief investment officer at Bessemer Trust. Rates on the 10-year Treasury are currently at 2.8%, up from 1.7% in May of last year. What's more, the Fed's tapering is likely to strengthen the U.S. dollar, "and as the dollar strengthens, as expected," Patterson says, "investors will be less willing to take the chance of losing some of their return in the currency translation."

Still, most wealth managers say that with selectivity, there are ways to make money in emerging markets. Private equity, for example, can be an effective way to capitalize on the well-known trend of the growing middle class in emerging markets. "If you look at the Brazilian stock market, the percentage of companies represented that give you access to the Brazilian consumer is small -- most are in exports and commodities," Patterson says, adding, "We want exposure to the consumer, and in private equity, you can do that by finding growing private companies and then taking them public."

In China, meanwhile, there's plenty of evidence to fuel both bullish and bearish arguments. The Passport Long/Short fund's Garry ties them together: "In China, we are negative on several commodities -- copper, iron ore -- and bullish on the burgeoning middle class," says Garry. "The best way to play that is through Chinese technology companies, particularly those related to the Internet. China restricts foreign competition, so if you can identify the leader, it's winner take all."

What we notice is even the topic of emerging markets quickly leads back to alternatives. Both private equity and hedge funds are attractive ways to get at very targeted opportunities in less-developed parts of the world, wealth managers insist. They are actually much more than that. When properly executed, alternative investments are a powerful means to further diversify the risks inherent in your portfolio. Hopefully, they will also earn you some decent returns in the process.

PRIVATE-EQUITY ALLOCATIONS JUMP 32%

Last year at this time, 40 of the nation's top wealth managers were busy convincing their clients to buy more equities. That's still true, as the equity allocation has risen to 51.1% from 48%. But that bullish call understates the bet on equities and where the real portfolio action is taking place. Move your finger over to alternatives, and drop down the hedge fund and private-equity columns. Private equity -- funds investing in, say, family businesses serving Brazil's middleclass -- has seen its portfolio allocation among the 40 managers rise from 2.5% last year to 3.3% this year.

That means, after years of little interest, banks and their clients are increasing private-equity allocations by a third. Hedge-fund allocations rose last year, too, but should see even more money flowing in as 2014 unfolds.

That's because the market volatility expected this year is likely to serve up the ideal conditions for long-short hedge funds to shine. Not to be forgotten, too, is the important role fixed income is playing in the rediscovery of alternative investments. With rates expected to rise, and bonds expected to tank, fixed-income hedge funds are seen as a substitute portfolio ballast. That might be a wise call, considering that fixed-income allocations have fallen steadily from 34% in 2012 to 26% today. Which really is the point of alternative investments. They can, when purchased the right way, further diversify the risks inherent in a portfolio.